International Finance and Financial Management - Essay Example

?International Finance & Financial Management Introduction: Value is one of the most critical terms in general sense as well as in the business environment. Every possible participant in any transaction seeks to gain the maximum value possible paying certain or even premium price. In the corporate world any sort of investment an investor basically makes is based on the fact that the ‘Net present value’ arising out of the project is satisfactory enough discounted by a certain effective return the customer thinks can enhance his value for his/her investment. Part 1 Shareholders’ and stakeholders’ value: Freeman, Harrison, Wicks, Parmar, & Colle (2010) observe that the primary objective for any business is to maximize its shareholders’ value as well as stakeholders’ value. The increase in shareholders’ value primarily results from the growth in the business with growth in top-line (sales revenue) and also increase in the bottom-line (profit). The shareholders of the organization contribute equity capital to the organization, which is required by the organization to grow and develop its business. So it is highly important that the organization provides maximum possible return to its equity shareholders. A company takes part in growth strategy by taking the path of acquisition, by venturing into completely new areas and also in new business basically to help the business grow thereby contributing to the growth in its profit. This helps in generating effective returns for its shareholders who are considered the owner of the organization. The company should basically look at value maximization of its shareholders and provide for the risk being taken by the shareholders’ in proving capital to the organization. The stakeholders of a company comprise all the participants who take effective part in the operation of the company. The stakeholders primarily include the customers who are the most important part of any organization, the suppliers of raw materials, the creditors, the employees, the community, the Government, the environment and even the shareholders’ who are directly affected by the business activities. (Freeman, Harrison, Wicks, Parmar, Colle, 2010, pp.128-131) Potential value of Synergies due to Acquisition: In recent times there has been a rapid increase in Mergers and acquisition activities. Companies are taking part in these activities effectively to enhance the business growing opportunities contributing to increase in shareholders’ wealth. Bosecke (2009) and Hunt (2009) observe that there is a set of complex reasons, which drive a firm to promote M&A activities. The Efficiency Theory clearly elucidates the main goal of M&A activities is to exploit synergies where synergy is basically the increased operational performance as a result of combined entity than that of single isolated firms. There may be positive synergies when the net combined effect of synergy produces more value than individual firms and if the synergy is not effective it causes negative synergy. There may be other synergies like Financial, operational and managerial synergies. The financial synergy basically results from lower cost, which calls for investment in unrelated business, which effectively reduces the systematic risk for the organization. Moreover capital costs can be reduced when the company grows in size and have access to cheaper capital. Sometimes larger companies basically venture outside to raise cheaper capital, as the cost of raising capital in countries like USA, Japan etc is very low. The companies, which are involved in mergers and acquisition internationally, can access the stock markets of those countries and in that case they have to comply with the specifications and regulations binding the process of accessing the international markets. This promotes international acquisition. The managerial synergy basically results when one less technically and functionally developed company derive benefit after getting merged with one technically and functionally expert company. However the basic reason for M&A activity is to capture the market outside and grow the business in outside market where there is a huge scope to grow. Also mergers often lead to reduce the competition because isolated firms compete among each other thereby snatching each other’s market share. In describing operational synergy, the basic benefit a company derives because of merger is the economies of scale, which explains more production by saving per unit cost that is by spreading the fixed cost in the process of achieving higher output. However the potential synergy that is derived from the acquisition effect ultimately leads to the growth of the organization. By virtue of acquisition, an organization can enter into newer areas and can potentially enrich itself with the technical, operational expertise of the other organization. It may venture into a completely newer segment and thereby attracting newer customers, which lead to its growth. The growth of the organization is ultimately linked with the potential value creation for its shareholders’ as the shareholders’ are considered the owners of the organization and form its management (Bosecke, 2009, pp. 25-28; Ray, n.d, pp.310-311; Hunt, 2009, pp.196-197). Dividend Policy Effect on Value Creation: Keown (2003) states that the dividends paid out by the company are considered essential for the benefit of its shareholders. For the purpose of investing in a company shareholders prefer a company, which pays enough dividends. There are companies like Hawkins, GE Shipping, Tata Chemicals, SRF, etc., which usually pay high dividends for its shareholders. Normally a company, which has generated higher bottom-line and does not have big projects in their hand usually pay the surplus cash to its shareholders in the form of dividends. But companies which are in growing phase and the companies which have bigger projects in their hand and also the companies which need enough cash for acquiring other companies thus making diversification and facilitating growth, actually plough back much of their profit for the purpose of expansion. In such circumstances dividend yields are usually low but the companies utilizing the cash, being generated from the operations, effectively yield value for shareholders. There are many companies which maintain a growth rate in its dividends regularly thereby helping their shareholders’ to earn part of their profit generated thus facilitate in creating value for them. So shareholders’ prefer companies, which have a modest dividend policy, and the rate of growth of their dividends is also good. Maintaining a good dividend growth rate ultimately enhances the value of a firm and also enriches the value of its shareholders. (Keown, 2003, pp.317-318) Value Investment and Warren Buffet: The value investment basically calls for buying stocks or in words of Peter Lynch buying businesses, which have high potential to grow to in future at a cheaper cost. Greenwald, Kahn, Sonkin, & Biema (2004), Whitman (2000) and Cunningham (2004) observe that the most fundamental ratios basically considered for the purpose of identifying cheaper businesses include the Price-earnings ratio (P/E) ratio, which calls for the price that the investor pays for every 1 rupee earning. Basically the companies having lower P/E ratios’ are considered safe. For the purpose of investment the P/E ratio of the company is compared with its peers in the market or with the P/E of the industry where the company is operating and if the P/E ratio of the company is lower the company is a safe bet to invest. However in this process of investment the company’s growth should be considered. Companies, which are growing at a faster rate, will boost the earnings, designated by the symbol E, which will help in reducing the value of the P/E ratio. Another important ratio that is considered is the P/BV ratio, which is Price/Book value ratio. The ideal condition for investing is that P/BV should be less than 1. But the book value should be the tangible net worth of the companies. There are companies producing leather goods and having many types of machinery, which are out of order but are shown in the balance sheet, thus increasing the net worth. This will reduce the book value apparently showing good investment opportunity, but in actual terms these companies are not at all safe bets. So investing on the basis of book value is somewhat risky if the tangible book value is difficult to gauge. (Greenwald, Kahn, Sonkin, & Biema, 2004; Whitman, 2000, pp.125-126 & Cunningham, 2004, pp.24-26) Buffet, & Clark (2002) observe that companies whose market capitalizations (number of outstanding shares*price of each share) are low are considered good for investment process. So it is important to invest in the small cap stocks, which have huge potential to grow. Companies, which are large cap, are already operating in almost full capacity utilization and have fewer opportunities to grow further. Warren Buffet, the greatest investor of all times always looks for “value investing” which basically signifies buying companies, which are cheap, having almost zero debt in their Balance sheet and strong potential to grow. (Buffet, & Clark, 2002, p.64) Part 2 Pricing of Risk: Risk is inherent in any organization. Although there is a saying that risk is correlated to return which explains more return generated for more risk taken, but the risk has to be effectively controlled otherwise the probability of loss or damage caused by unforeseen events can be huge. Corporate Risk management: The risk management is not any isolated activity. Proper prediction and planning facilitates risk prevention. This process helps in addressing both insurable and non-insurable risks and it involves systematic identification, analysis, quick response and provision of suitable contingencies to events causing risk thus to obtain optimum risk elimination and control process. The identification process involves gathering of suitable information from different sources and to address the gaps in the current information to obtain lucidity and unambiguity of understanding the project. The different types of risks involved are credit risk which involves payment default by the debtors, operational risk which arises due to faulty system in the operation process like problems in the information database or manufacturing defect etc, liquidity risk which is mainly faced in banks and financial institutions when the company has more long term investments with longer maturity tenure and short term payment obligations. This is primarily caused due to maturity mismatch, investment and market risk which arises due to fluctuation in the market conditions and may cause huge erosion of wealth, currency risk which is caused due to fluctuations in the currency conversion rate. An organization, which has a huge payment to be made to, an outside country will suffer if there is depreciation in the foreign currency. Similarly an organization having a lot of receivables in home currency will suffer if there is a sudden depreciation in home currency. (Merna, & Al-Thani, 2011; Chew, 2008, pp.49-51; Koller, & Koller, 2007, p.28) In this context of risk identification the global credit crunch named as ‘subprime crisis’ which occurred in 2008 was primarily due to default by the subprime borrowers. In those times in United States easy loans were available and in this instance many subprime borrowers whose credit ratings are too low to qualify for any loan easily got loans without much stringent credit assessment policy. Their houses were being mortgaged. When these borrowers started to default the financial institutions took charge of their houses and with so many houses in their charge the price of real estate and houses started decreasing in a steep manner and there was huge selling pressure and liquidity in the system almost vanished causing liquidity crunch. (Russo, Katzel, Russo, & Katzel, 2010,pp.10-11; Neave, 2008, p.510) Hagin (2004) observes that intelligent investing helps in reducing risk. He is basically talking of diversification process, which consists of investing in a basket of securities in unrelated sectors, and companies with less positive correlation among themselves and this can effectively negate the risk to a large extent. (Hagin, 2004, p.239) Definitely risk has got some price attached to it. The equity investors definitely ask for more prices making the cost of equity more than the cost of debt. The cost of equity can be shown as Ke= Rf+Beta*(Rm-Rf) + Lambda Ke stands for cost of equity, Rf stands for risk free return, Beta stands for market risk, and Rm stands for market return. Here the risk free rate of return Rf shows the return available from Government bonds, which are considered risk free for the investment process. The parameter lambda comes into account for investors investing in markets outside where lambda represents the country risk premium, the premium to be paid to shareholders for investing in outside countries having completely unknown risk. The factor beta*(Rm-Rf) is the extra charge demanded by the equity shareholder for the risk involved in investing in the company. Beta is the market driven risk, which is associated with the operation of the company in the market. The parameter beta varies from company to company. A company having lower beta has lesser risk compared to more beta. Risk associated with different cash flows: The cash flow is important for any business to operate, as cash is the most liquid resource. As in countries like India where accrual basis of accounting is used, the revenue balance on a particular day does not tally with the actual cash flow on that date. So cash flow statement is very essential. According to Moyer, McGuigan, & Kretlow (2008), the risk associated with the cash flow influences the market value of a stock. The financial managers should take into account the risk associated with the cash flows, which are expected to be generated in future because this will get reflected in the valuation of the enterprise. The factors which influence the future cash flows can be related to external macroeconomic factors which basically include the economic activities, the regulations concerning the tax rates, the competition, currency exchange rates, the inflation and the present international business situations which are outside the scope of the managers to handle. Other possible factors include the internal factors which include the product quality, the technological expertise, the distribution channels, the employment compensation policies, the ownership structures which show how much stake the present management has in the company, the capital structure which takes into account the proportions of debt as using more debt and exceeding the margin of safety can become hazardous as it promotes more fixed interest to be paid, thereby reducing the earning per share (EPS) and affecting cash flow system. The dividend policies-companies paying more dividends attract more shareholders and this in turn attracts more investments allowing the business to develop further and increase in cash flows. So there is a deep risk involved with not only the future expected cash flows as the future is uncertain but also with the operational cash flows due to the factors discussed as internal management issues. (Moyer, McGuigan, & Kretlow, 2008, pp.11-12) Predicting the future: Duffey & Saull (2008) observe that although the prediction of future is difficult we can somehow manage to quantify the perceptions for relative risk on the basis of probable expectations of our learning behavior based on certain number of previous outcomes. So what actually comes out is that depending on the distribution of previous outcomes and experience, the perception of risk can be truly reflected. The author here talks about designing the risk formula on the basis of corrected data collected from previous uncertain events. But data exists in fragmented form and becomes difficult to accumulate. Till date only few selected industries have been able to collect the corrected data. Although this appears frustrating taking into account the highly developed technological state we are in, the situation is exactly like this in the current scenario. 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